Policies To Combat High Inflation

This section takes a close look at the role of structural reform in growth and assesses the progress made in the Asian economies. Some conclusions follow.

Fiscal consolidation and early, extensive agricultural reform were key to successful disinflation in the Asian economies. The fiscal consolidation-disinflation nexus witnessed in the CEE-BRO economies was repeated. China’s fiscal position, already strong at the outset, required only modest adjustment. Sizable fiscal tightening undertaken in Laos and Vietnam initially focused on expenditure cuts and later on revenue enhancement (Dodsworth and others, 1996b). In Mongolia, the availability of substantial external assistance reduced the need for domestic financing to bring the budget deficit down to a reasonably low level.

Exchange rate policy in all the Asian countries was flexible, with movements in the free market rate a key indicator for the official exchange rate. None of these countries used the exchange rate as a nominal anchor for stabilization, a feature that parallels the limited use of formal exchange rate and monetary targets in the CEE-BRO countries. The Asian economies, known to be undertaking structural change, with its attendant uncertainty, clearly had inadequate international reserves to make official pegs credible. The monetary framework in each country was discretionary. Laos and Mongolia relied on Fund-supported programs to enhance credibility.

Disinflation and Inflation Stabilization

Tight financial policies were successful in reducing inflation in Laos, Mongolia, and Vietnam (Figures 2 and 3). Inflation in Laos was held to 10 percent during 1991 and remained in single digits until the end of 1994, but rose steadily during 1995 and the first half of 1996, to settle in the 10–25 percent range. In Vietnam, inflation was reduced to 35 percent during 1989, and after increasing again to almost 70 percent in 1990–91, declined to single digits during 1993–94. It rose to 15–20 percent during 1994–95, before falling again to single digits during 1996–97. In Mongolia, inflation was reduced to single digits in 1998. In China, inflation never crossed moderate double-digits levels.

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Fiscal Indicators in Four Asian Transition Economies, 1989–98

(In percent of GDP)

Sources: World Economic Outlook and IMF staff estimates.¹Domestically financed deficit.²The fiscal year was changed from a calendar year basis to an October–September basis in 1992.

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Notwithstanding successful disinflation, the experience of the Asian economies exemplifies the difficulties in keeping inflation consistently low over a long period. The disinflation gains in Laos were reversed in 1997; inflation in China has persisted at moderate levels for some time and has displayed a significant cyclical pattern. These developments and the experience of some advanced transition economies of CEE suggest that inflation performance may remain variable and moderate inflation may persist in transitional economies for a long time. Advanced transition economies may already be subject to inflation cycles of the type witnessed in market economies. Furthermore, as the transition progresses and inflation falls to more moderate levels, the link between fiscal tightening and disinflation may grow weaker.

Inflation and Growth in Transition

Strong output growth in the Asian transition economies (excluding Mongolia) during the disinflation period contrasted sharply with CEE-BRO experience. This growth was buoyed by a significant supply response from agriculture. In addition, contrary to deteriorating current account balances experienced in the CEE-BRO, the Asian economies benefited from improved external accounts and a rapid buildup of reserves associated with high export growth and low fiscal deficits. Moreover, import growth was relatively modest and often driven by investment needs.

Recent analyses have suggested threshold levels may exist in the relationship between inflation and growth (Sarel, 1996, and Ghosh and Phillips, 1998). This hypothesis is tested for the CEE-BRO transition economies by Christoffersen and Doyle (1998), who estimate the threshold level of inflation at about 13 percent, higher than in industrial market economies. Cottarelli and Doyle (in this volume) suggest that this higher threshold inflation may indicate that the threshold level falls during transition and may be lower for the advanced reformers. For the Asian countries, no clear indication of a threshold level of inflation is evident (Box 1). Adding the four Asian transition economies to Christofferson and Doyle’s panel data set reduces the inflation threshold to about 8 percent.

These results suggest that, while inflation has inhibited growth in Asian transition countries, no evidence supports the view that the size of the negative effect increases when inflation passes a certain point. More work needs to be done to explain this phenomenon, which may in part reflect more moderate relative price distortions because of the larger share of agriculture in total output (Coorey and others, 1998). Also, the estimated fixed effects for the Asian transition countries are higher than those of the CEE-BRO economies, indicating that growth in the Asian countries has been stronger than in non-Asian transition countries for given levels of inflation.

Box 1.

Inflation and Growth in Transition Economies

Recent analyses have suggested that threshold levels may exist in the relationship between inflation and growth: above the threshold inflation and growth may be negatively related, but below this level there may be no clear (or even a positive) relationship between growth and inflation (Sarel, 1996; and Ghosh and Phillips, 1998). Using Sarel’s methodology, Christoffersen and Doyle (1998) test this hypothesis for the CEE-BRO transition countries and find a threshold level of inflation of about 13 percent, higher than in industrial market economies (Ghosh and Phillips). For the Asian transition economies, no clear threshold level of inflation is apparent. Using an augmented data set that includes Asian transition economies, the threshold level of inflation falls to 8.

The simplest version of the equations estimated in Christoffersen and Doyle is:

$\begin{array}{cc}{g}_y=b_1*\mathrm{log\pi }+b_2*(\mathrm{log\pi }-\mathrm{log\pi }*)+\mathrm{fixed}\mathrm{effects}\mathrm{and}\mathrm{control}\mathrm{variables},& \left(1\right)\end{array}$

where g_y is growth rate of GDP, π is inflation, and π* is the threshold level of inflation. The threshold value of inflation is defined as the value that maximizes R² for (1). For the variable inflation minus threshold, negative values are assigned the value zero. The coefficients are interpreted as follows: if inflation is below the threshold level then inflation has the coefficient b₁, whereas if inflation is above the threshold the coefficient becomes b₁ + b₂. Cottarelli and Doyle (chapter 3 in this volume) suggest that differences between transition and industrial countries may suggest that threshold levels of inflation may fall in “transition” time, and may be lower for the advanced reformers.

Figure B1 shows a cross-plot of growth and inflation for the four Asian countries; no clear indication of a threshold level of inflation is apparent. The four Asian transition economies were added to Christoffersen and Doyle’s panel data set and equation (1) was estimated using fixed effects, allowing the two groups of countries (Asian and non-Asian) to have different fixed effects. The reestimated equation is:

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Inflation and Growth in Asian Transition Economies

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$\begin{array}{ccc}{g}_y& =\underset{{\displaystyle \left(2.40\right)}}{1.66*\mathrm{log\pi }}-\underset{{\displaystyle \left(5.81\right)}}{5.55*}(\mathrm{log\pi }-\mathrm{log\pi }*)\hfill & \left(2\right)\\ R^2& =0.54S\mathrm{.}E\mathrm{.}=7.64\hfill \end{array}$

Two results follow this reestimated equation: First, the fixed effects of equation (2) is 7.0 for the Asian transition countries and 1.6 for the non-Asian transition countries. This indicates that for the same level of inflation, growth was higher in the Asian transition countries. Second, the inflation threshold for the augmented data set is 8. (The R² from the estimation using the Christofferson and Doyle augmented panel data set is shown in Figure B2.)

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Threshold Levels of Inflation

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Other Asian Transition Economies: The Pitfalls of Partial Reform

The experience of other Asian transition economies echoes themes heard in the case of China and the CEE-BRO economies (see appendix for details):

• Exogenous shocks and domestic discontent with the performance of centrally planned systems provided the initial impetus for the move to market-based systems. This sequence was perhaps clearest in Mongolia where the disruption stemming from the loss of transfers from the former Soviet Union and the breakdown of the CMEA system was most debilitating, and the collapse of the former Soviet Union provided the opportunity to break away from a grudgingly accepted economic system. Ironically, Laos initiated a move to decentralized decision making in 1979 when the loss of Western aid and an economic embargo combined with poor weather conditions to precipitate economic collapse.

• The large agricultural sector, perceived as an advantageous initial condition for many reasons, is often suggested as a factor in avoiding output collapse in the transition economies of Indochina (Dodsworth and others, 1996a and b; Woo and others, 1997). Institutional structures in agriculture are, or can rapidly become, more flexible than those in state-owned industrial enterprises and thus permit a more rapid supply response to price incentives.⁶ Other advantages have also been cited. Agricultural growth is a natural developmental process, and in the Asian economies it helped absorb rural labor surpluses. Agriculture also helped alleviate redundancies from the industrial sector because it had less pronounced wage and price rigidities. In contrast, the transition in the CEE-BRO economies involved reversing overindustrialization and costly, socially painful labor retrenchment.

• The choice of speed and scope of the transition—in the initial stages and as the transition progressed—was heavily influenced by initial conditions, political acceptance of the market mechanism, the ease with which difficulties associated with partial reforms could be contained initially and eventually remedied, and the availability of external financial assistance and foreign direct investment flows.

• Within the Asian economies, the experience of Vietnam was similar to that of China: the market was seen as an instrument for higher growth and was introduced selectively and in stages. Administrative measures continue to play an important role in the nonagricultural sector, and the trade regimes remain relatively restrictive. Laos and Mongolia also have similarities: there is an acceptance of the market, the role of administered prices is minimal, and outward orientation is strong. Greater reliance on decentralized decision making and market forces is also reflected in privatization, which is quite advanced in both countries, even in the nonagricultural sector.

• Decentralization was often initiated in response to popular unrest with central control (as in Laos). Furthermore, once initiated, the process was not always fully controllable. Many “spontaneous” privatizations took place in Mongolia, decision making was often under weaker control in the agricultural sector in Vietnam than had been envisaged, and asset stripping was often encountered in state-owned enterprises. These developments underline the need for a transparent and effective legal and regulatory framework to assist the transition.

• China’s and Vietnam’s selective and gradualist strategy appears to have provided rich dividends, but cannot be seen as unambiguously validating gradualism. Indeed, high growth came from agriculture in which reforms were the fastest. The speed and depth of the reforms in this sector were akin to the shock therapy applied in many CEE-BRO countries. Furthermore, as the scope for further efficiency gains in agriculture is narrowed, the need to widen the range of reforms is becoming more apparent.

• As the transition unfolds, the response to impending instability has been unpredictable. At times, macroinstability has spurred liberalization and reform (as in Vietnam in the mid-1980s); at other times, most recently in Laos and Vietnam in the wake of the Asian crisis, some backtracking and recourse to old methods of control and command have occurred.

• Partial reforms inevitably generated tension and macroeconomic imbalance, suggesting the need to continue, and often spurring, the reform process. The dual track pricing and exchange rate systems in Laos and Vietnam were useful in providing market signals at the margin, but they also produced macroimbalances when market and official rates were unsynchronized and generated considerable scope for corruption and rent-seeking activity. Similarly, continuing weakness in the financial system, governance problems, and absence of controls over access to bank credit by enterprises encouraged inflation. Such factors generated a crisis in Vietnam in the late 1980s and price and exchangemarket instability in Laos in late 1994, and they threatened to reverse inflation reduction in Mongolia in 1998.

• The need for reform of state-owned enterprises and of the financial sector is increasingly apparent in the Asian transition economies. Because the growth impetus from agriculture appears to have diminished, further sustained growth will have to come from elsewhere, perhaps from a combination of light, export-oriented manufacturing and further development of services. To provide room for these sectors, the claim of state-owned industrial enterprises on resources would have to be progressively reduced. The inefficiency of enterprises is only masked by budgetary subsidies, quasi-fiscal deficits, and state support through protectionist trade policies. The adverse effects are manifest in the weak commercial bank balance sheets and reflect poor managerial and risk assessment skills. Reforms in the financial sector are urgently required to maintain macrostability and to provide efficient financial intermediation to support growth.

Vietnam

Favorable conditions at the outset facilitated Vietnam’s transition. Agriculture accounted for almost 40 percent of output. The economy was only loosely integrated with the CMEA system. Furthermore, substantial foreign savings available from fast-growing neighbors combined with the fortuitous coming-on-stream of domestic oil production in the early 1990s to relieve important growth constraints. On overall objectives, the official position has been that Vietnam does not aspire to become a full-fledged market economy; instead the market mechanism is intended to promote growth and ensure overall stability (Reidel and Comer, 1997, and Mihaljek, 1998). Reflecting these overall objectives, the pace of reforms has varied. Reforms in agriculture have been substantial with extensive, progressive decentralization, and liberalization. Reforms in the financial and enterprise sectors have lagged behind, and the Asian crisis has led to some backtracking.

Reforms were first undertaken in late 1979 after the Sixth Plenum of the Fourth Party Congress. The most important steps were taken in agriculture, where responsibility for output targets was shifted from the cooperatives to households. Surpluses above the targets could be retained and traded. This change in the contractual arrangement was very successful and agricultural growth increased sharply. These reforms were carried further in 1986 under doi moi (economic renovation), in which quota obligations were eliminated and all agricultural produce could be sold in the market. Still deeper reforms came in 1988 with the introduction of long-term land leases, which were transferable under specified circumstances. With this important step, almost all operational control over the dominant sector of the economy had moved to private hands. Other reforms were also undertaken: the state monopoly over international trade was dismantled, quotas were replaced by import duties (albeit at high levels), and steps were made to attract foreign investment.

The onset of a macroeconomic crisis in early 1989, following the collapse of the former Soviet Union and the CMEA, spurred price liberalization, exchange rate unification, and the dismantling of extensive state controls over internal trade. By then, the system of administered prices and exchange rate controls had resulted in widespread parallel markets, broad divergences between official and black market prices, and a grossly overvalued dong. The stabilization program included a sharp fiscal contraction, unification of the multiple exchange rates at the level of the parallel market (entailing a fivefold increase in the official rate), and a substantial increase in interest rates. By mid-year, the program was successful in reducing inflation significantly. The fiscal consolidation continued during 1989–91 as government lowered its spending by 6 percent of GDP through large reductions in budgetary subsidies, capital outlays, and the wage bill, including an extensive demobilization of the armed forces.

Reflecting the philosophical basis of the reform strategy, as the macroeconomy stabilized and a balance of payments crisis was averted through large rice and oil exports, the reform imperative receded after 1992, and a large unfinished agenda remains. Significant obstacles remain in the path of an open and liberal trading regime, including continued targeted support to import-substituting state industries and control over the exchange rate and trade flows through rationing of foreign exchange in the interbank market. While a two-tiered banking system has been established, the central bank needs to assume its role as guardian of macroeconomic stability by developing the necessary market-based instruments of monetary management. Restrictions on commercial banks have been reduced over time and a growing number of foreign banks have been permitted to open branches. Nevertheless, domestic commercial banks remain large public institutions, dependent on the central bank and accustomed to lending to state enterprises without credit-risk appraisal. Progress in the reform of state enterprises has been minimal and loss-making enterprises continue to remain afloat through protectionist measures and directed credit from the banking system.

Laos

In Laos, the disappointing performance of the centrally planned economy, established in 1975 after two decades of protracted civil war, provided the impetus to a market-based system in 1979 (Otani and Pham, 1996). The overall commitment to a market economy has been strong, even though implementation of reforms has lagged at times.

The seeds for transition to a decentralized system may have been sown when already low living standards deteriorated because of poor output performance and high inflation soon after central planning was introduced. External and internal resistance to central planning was strong. Aid from Western nations, especially the United States, came to an abrupt end. The economic blockade of the country disrupted trade flows. Internally, resistance in the agricultural sector to forced collectivization and taxation was lively and dissent from the new system was reflected in a flight of skilled human and financial capital. Stagnant exports and the loss of import financing combined to generate considerable pressure on the balance of payments. Widespread parallel markets mirrored the shortage of goods.

Substantive progress was made in economic liberalization and structural reform over the first decade (1979–88), creating a foundation for private sector activity. The reform process gathered momentum under the New Economic Mechanism as the system of official prices based on “cost plus pricing” was abandoned in favor of the principle of “one market, one price” in mid-1987. Almost all retail prices were liberalized, eliminating the distortions created by a two-track pricing system. The progressive easing of restrictions on internal and external trade starting mid-1987 also facilitated the process. The unification of multiple exchange rates at a level close to the prevailing parallel market rate in early 1988 helped in eliminating distortions. Moreover, starting in 1983, larger numbers of public enterprises were free to make production, pricing, employment, and wage decisions and were held accountable for their budgetary obligations. However, banking sector reforms lagged and negative real deposit interest rates continued to hinder resource mobilization.

Since 1988, reforms have focused on raising domestic savings through fiscal consolidation and positive real interest rates, and on inflation reduction through limits on credit expansion to state-owned enterprises. Fiscal consolidation has been centered on a fundamental reform of tax administration, elimination of budgetary subsidies, and rationalization of expenditure priorities. The final steps in external sector liberalization, which had contributed to substantial export growth, were taken in mid-1994 with the elimination of all restriction on international current account transactions. Progress was also made in financial sector reforms, including the opening up of private banks and improvements in monetary control. However, monetary management continued to be complicated by the financial sector’s tendency to accommodate credit demands passively, resulting in excessive wage increases by the enterprises.

A lax monetary stance in late 1994 and early 1995, combined with the initial effects of import liberalization, led to a strong surge in demand. A period of inflation and exchange market instability ensued. The initial policy response—small depreciation in the official exchange rate and administrative controls—proved inadequate as transactions shifted to the parallel markets, widening the divergence between the parallel and official rates.

As remedial fiscal measures were undertaken and monetary conditions tightened, in conjunction with the removal of exchange restrictions and the abolition of the official exchange rate in mid-year, macro-economic stability returned and inflation receded. Simultaneously, curtailment of budgetary subsidies and the privatization of state-owned enterprises hardened enterprise budget constraints. Since, however, these enterprise reforms met with limited success, the government embarked on a broad program of disengagement from all nonstrategic enterprises. Later divestment from strategic enterprises was initiated and, by early 1997, the privatization process was nearing completion. With the basis for a market economy well-entrenched by the end of 1998, the reform agenda now calls for improvements in the banking framework to promote efficient financial intermediation, resolution of insolvency among banks, and greater flexibility in the foreign exchange market to reduce dollarization and enhance confidence in domestic financial assets.

Mongolia

Among the Asian transition economies, the commitment to a market-based economy was perhaps strongest in Mongolia, where longstanding unease with Soviet planning is often cited for the relatively readier acceptance of a market orientation (Boone and others, 1997). In addition, the age structure of the young population favored a move to a new system. Concerted efforts to install a democratic system of government with general elections at an early stage supported this favorable climate. The broad consensus in favor of the required transformation was reflected in the inclusion of important opposition members in the coalition government formed by the former communist party (the MPRP) in 1990. When the former Soviet Union and the CMEA system finally collapsed in 1991, the external shock—a substantial loss in transfers from the former Soviet Union and a sharp decline in trade volumes—was large even by comparison with the dislocation affecting the CEE-BRO countries. Western donors filled the budgetary and external financing gaps, providing foreign financing of the budget through project and cash loans in the range of 10–15 percent of GDP.

Favorable conditions for change notwithstanding, only partial reforms were undertaken initially, reflecting differences within the government on the speed and scope of reform. Some price and trade liberalization was undertaken, a voucher privatization program—the first in a transition country—was initiated, and the banking system was deregulated. Partial reforms soon resulted in a loss of monetary control and near hyperinflationary conditions in 1992–93. Macroeconomic instability was closely associated with a lack of significant reform in the enterprise and financial sectors, which permitted commercial banks to start operations under weak bank supervision, poor bank management, and considerable insider lending.

Conditions for macroeconomic stability were restored only in mid-1992 after fresh elections returned a clear parliamentary majority for the MPRP. The new government made significant progress in unifying the exchange rate, eliminating all quantitative export and import controls by mid-1993, and improving tax administration and budget management. Together with progress in macroeconomic stabilization, these initiatives led to real GDP growth in 1994 after a prolonged decline, reflecting a rebound in the livestock sector, higher exports in response to a recovery in export prices, and accelerated growth in the construction and service sectors.

The pace of structural reforms accelerated during 1994–95 and received fresh impetus from the electoral victory of the reform-minded coalition of opposition parties in mid-1996. Progress in privatization was especially noteworthy. By the end of 1994, livestock was almost entirely in private hands and the voucher-based privatization program was complete. By the end of 1995, through a cash privatization program, most small and medium-sized enterprises had been privatized. A thriving secondary market in private housing developed by the end of 1997. A notable development, which reflected the boldness of the reform policies, was the complete elimination of import duties in early 1997, which enhanced the already substantial outward orientation of the economy. A major bank restructuring was initiated at the end of 1996, and tax reform, including the introduction of VAT, was undertaken in mid-1997.

The reform effort stalled in 1998. As principal export prices fell, the deterioration in the external environment exposed weakness in the financial system, including poor supervision, bad commercial bank management practices, and corruption in large state-owned enterprises. Domestic political turmoil further delayed the implementation of corrective fiscal measures.

With political conditions more settled starting at the end of 1998, the current challenge is to restore the reform momentum while locking in the low inflation and resilient growth performance of 1998. In particular, substantial efficiency gains could be garnered from comprehensive bank restructuring to resolve insolvency of commercial banks and from further reduction in the size of government, more transparency in the enterprise sector, and the completion of state divestment of the large enterprises and utilities.